Understanding Uncertainty Shocks and
the Role of the Black Swan
Frequently Asked Questions

by Anna Orlik and Laura Veldkamp

Q: What is black
swan risk and why does it vary over time?

It is a rare event that we may have never before
observed. Its estimated probability changes, not because the world
changes, but because new data prompts us to re-estimate the distribution
that governs the probabilities of all events.

Q: How do we
measure black swan risk?

We estimate a smooth distribution that best fits the
empirical frequency of observed data. Sometimes called kernel density
estimation, it is like plotting a histogram of all the GDP data
observed in the post-war data sample and then fitting a function to match
that histogram. While kernel
density estimation is a fairly standard procedure, we put two twists in
that procedure that help us to fit the data and produce forecasts that
look more like professional forecasts. First, we estimate non-normal
densities that have parameters which regulate skewness. Second, we not
only estimate the distribution, but we estimate our uncertainty about the
estimates of the distribution. In doing so, we acknowledge that
uncertainty comes not only from having volatile outcomes, but also from
our own imperfect understanding of the macroeconomy.

Once we have an estimated probability distribution (in
fact a family of distributions, each with its own probability), we
integrate the probability mass in the left tail of the distribution. That
cumulative probability reveals the probability of an extreme negative
event.

Q: Why does
black swan risk matter?

Volatile and counter-cyclical disaster risk is one of
the leading theories of equity risk premia. A vulnerability of this
explanation is that we cannot observe the risk and do not have an
explanation for why it fluctuates when no disaster is imminent. Estimating
black swan risk offers one such explanation. When agents continually
re-estimate continuous probability distributions, seemingly innocuous data
can change the shape of the estimated distribution in a way that swings
tail probabilities around. Using these tools, we can determine whether
disaster probabilities fluctuate enough to explain risk premia.

Another important contribution of this set of tools is
that they help explain slow economic recoveries in the wake of crises.
When agents use data to estimate distributions, new observations create
permanent changes in beliefs. A very low growth rate, for example, will
never disappear from the data. Forever after observing such an event,
agents will continue to have a higher estimate of extreme low growth rates
because of its single occurrence. This persistent effect could help
resolve one of the main challenges to belief-driven business cycle
theories: that shocks fail to have persistent effects.While the economy bounces back quickly from some recessions, it
recovers slowly from others because they involve data realizations that
permanently change beliefs about the distribution of future outcomes.

Finally, swings in tail probabilities have the largest
consequence is for financial claims that are very sensitive to left tail
events. Debt is one such asset. Its payoff is constant in most cases,
except for default. Thus, the value of debt is sensitive to the risk of an
extreme, negative event that would trigger a default. Since most firms
have never defaulted, this is a never-before observed event for that firm.
Estimating the probability of such an unobserved tail event is exactly
what this set of tools is designed to do.

Q: How can I use
this tool for my own research project?

The fact that people do not know the true distribution
of outcomes has two consequences for probability or uncertainty estimates.
The first is that new data will trigger changes in estimates. The second
is that these estimates are themselves uncertain. Much of the fluctuation
in rare-event risk arises just from re-estimating the distribution, and in
particular, adjusting the parameters that govern skewness. Estimating a
distribution in real time is simple. Commands like ksdensity
in MATLAB allow you to do this instantly. A simple approach to adopting
this idea is to take the stand that agents act like econometricians and
estimate the probability of outcomes each period from realized data. Once
they estimate that distribution, they take it as truth until the
re-estimate next period. While this myopia, ignoring future re-estimation,
creates tension in an otherwise rational model, it has a considerable
intellectual history and removes most of the computation complexity from
the problem.

Some results, such as the presence of forecast bias, do
hinge on having agents who acknowledge their uncertainty about their own
estimates. To compute this, we use a standard Metropolis-Hastings
algorithm, coupled with a non-linear change of variable at the start. See
the appendix of Orlik and Veldkamp (2014) for more details.